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Session 7-9

The document discusses the Altman Z-score, which is a formula that uses ratios to determine the likelihood of bankruptcy for manufacturing companies. The formula considers profitability, leverage, liquidity, solvency, and activity ratios. A score closer to 1.8 suggests a risk of bankruptcy, while a score closer to 3 suggests solid financial positioning. The document then provides the specific ratios used in the Altman Z-score formula for publicly held and private manufacturing firms.

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Joydeep Gorai
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60 views54 pages

Session 7-9

The document discusses the Altman Z-score, which is a formula that uses ratios to determine the likelihood of bankruptcy for manufacturing companies. The formula considers profitability, leverage, liquidity, solvency, and activity ratios. A score closer to 1.8 suggests a risk of bankruptcy, while a score closer to 3 suggests solid financial positioning. The document then provides the specific ratios used in the Altman Z-score formula for publicly held and private manufacturing firms.

Uploaded by

Joydeep Gorai
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
Download as pdf or txt
Download as pdf or txt
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Session 7-9

Altman Z score
• After M score, let study different versions of Z score.
• The Altman Z-score is a formula for determining whether a
Altmannotably
company, Z in the manufacturing space, is headed for
Score
bankruptcy.

• The formula takes into account profitability, leverage, liquidity,


solvency, and activity ratios.

• An Altman Z-score close to 1.8 suggests a company might be


headed for bankruptcy, while a score closer to 3 suggests a
company is in solid financial positioning.
As Z score include all ratios, Let recall all ratios
along with their calculations
Operating cycle (Cash conversion cycle)
Which industries are expected to have longer cycle and why ?

What does negative operating cycle indicate? Is it good or bad?


(Ninth world wonder-Finance)

Negative working capital or CR less than one.


Gymshark’s cash cycle is particularly impressive compared to that of other players
in the fashion industry, who rely heavily on physical retail to sell their products, thus
naturally yielding higher days receivable.
Trading on equity/ capital gearing/ Financial
leverage
• Refer your notes
Is debt cheaper than equity?

 Levered firms
High geared firms Debt > Equity.
Low geared firms) Debt < Equity.
 Unlevered firm
Firms can take advantage of financial leverage. It is called Trading on equity.

Let see this with an example (Excel) (Refer your note book)
What is good or bad gearing ratio?
(It’s difficult to say or comment anything)

What Industry Typically Has the Highest Debt-to-Equity Ratios?

Which industry has higher gearing ratio, and low gearing ratio and
why?
Profitability ratios
• Dupont and modified DuPont analysis
Dupont analysis
Modified Dupont framework
Numerical questions
• GP ratio 15%
• SV = 6 months
• DV = 3 months
• CV = 3 months
• GP = 60000
• CS is equal to OS.

• Calculate Sales, Closing stock, Debtors and creditors. (400000,


170000, 100000, 85000).
Questions on operating cycle
Calculate Debtors and creditors
✓Sales Rs. 20 Lakhs.
✓Gross profit ratio is 20%.
✓Closing stock is one and half times of opening stock.
✓Stock velocity 3 months.
✓Debtor turnover ratio is 3.
✓Creditors velocity 3 months
✓Sales return (Return inward) Rs.3,00,000.
✓Purchase return (Return outward) Rs. 40, 000.
✓Three-fourth goods are sold on credit, whereas only 40% purchases are
made on cash.
Prepare an estimate of working capital requirement from the following information of a
project :

• Projected annual sales Rs. 6,50,000


• Percentage of net profit on sales 25%
• Average credit period allowed to debtors 10 Weeks
• Average credit period allowed by creditors 4 Weeks
• Average stock holding in terms of sales requirements 8 Weeks

• Allow 20% for contingencies

(Answer: Rs 157500)
Calculate working capital
27076.92
Rs. 4,12,500
Prepare an estimate
of working capital
requirement:
Rs. 35,35,000
Prepare balance sheet from given information:

✓Stock velocity : 2 months


✓Capital turnover ratio (COGS/Capital): 2
✓Fixed asset turnover (COGS/FA): 4
✓GP Ratio: 20%
✓Debtors' velocity: 2 months
✓Creditors velocity: 73 days
✓Gross profit is Rs.60000
✓Reserve and surplus amounts to Rs.20000
✓Closing stock was Rs. 5000 in excess of opening stock.
Prepare balance sheet from the given information

✓Current ratio : 1.75


✓Liquid ratio : 1.25
✓STR : 9
✓Gross profit 25%
✓Debt collection period : 1.5 months
✓Reserve and surplus to equity capital : 0.2
✓Turnover to fixed assets (cost of sales/FA) : 1.2
✓Capital gearing ratio (long term debt to equity capital) 0.6
✓Fixed assets to net worth: 1.25
✓Sales Rs. 12 lakhs
Perform DuPont and modified DuPont based on the
following information
✓Assets 10 Lakhs, out of which 4 lakhs is raised through 8% debt.
✓Revenue 22 Lakhs
✓Tax rate 30%
✓Net income 1.8 lakhs
Can be P/E Negative? Is it good?
Calculate dividend yield and earnings yield
✓Market value per share Rs. 150
✓Earnings per share Rs. 25
✓Retention ratio 30%.
Prepare balance sheet
✓GP ratio : 25%
Liabilities Am (Rs.) Assets Am (Rs.)
✓NP ratio : 20% Capital Fixed assets
Net profit Stock
✓Sales/Inventory ratio= 8 Total outside liabilities Other current assets
Total Total
✓Fixed assets/ total current assets = ¾
✓Fixed assets/ total capital= 3/2
✓Capital/total outside liabilities = 2/5
✓Fixed assets = 15 lakhs
✓Closing stock 2 lakh
Prepare balance sheet
✓Sales 32 lakhs
✓Sales to net worth 42% Liabilities Am (Rs.) Assets Am (Rs.)
Net worth Fixed assets
✓Total debt to net worth 75% Long-term debt Cash
✓Current ratio : 2.9 times Current debt Stock
Debtors
✓Net sales to inventory 4.7 times Total Total

✓Average collection period 64 days


✓Fixed assets to net worth 53.2%
After understanding ratios, let back to our
discussion on Altman Z score.
• The Altman Z-score is a formula for determining whether a
Altmannotably
company, Z in the manufacturing space, is headed for
Score
bankruptcy.

• The formula takes into account profitability, leverage, liquidity,


solvency, and activity ratios.

• An Altman Z-score close to 1.8 suggests a company might be


headed for bankruptcy, while a score closer to 3 suggests a
company is in solid financial positioning.
Publicly Held Manufacturing Firms with more than $ 1 million of net
worth values.

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5

A higher score indicates a lower bankruptcy risk, while a lower score suggests a higher risk.
Z-Score estimated for Private manufacturing
Firms

Z = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5

Zones of Discrimination

• Z' > 2.9 “Safe” Zone

• 1.23 < Z' < 2. 9 “Grey” Zone

• Z' < 1.23 “Distress” Zone


Benford’s Law
Benford’s law (also known as the first digit law or Benford’s
distribution), is a distribution that the first digits of many (but not all)
data sets conform to.
Procedure of Application of Benford’s Law
• Isolate first digit of different numbers of financial statements.
• Make a frequency table of the numbers ranging 1-9.
• Compare the standard distribution with actual distribution
• Expected Distribution = log10(1+(1/d)) for d= 1,2,3…..9
• Calculate cumulative difference using actual – standard.
• Find out maximum value of cumulative difference called KS.
• Find out cut off point using this equation = 1.36 / srqt (total No.)
• Decision point = if KS is above cut off point then it indicates the
chances of financial statement manipulation.
Leverage analysing
Finance Modeling Debt
Service Cover Ratio
Debt Sizing and Debt sculpting
✓Debt sizing refers to the project finance model mechanics for
determining how much debt can be raised to support an
infrastructure project.

✓Debt sculpting is a commonly used term in project finance. It means


that the principal repayment obligations have been calculated to
ensure that the principal and interest obligations are appropriately
matched to the strength and pattern of the cash flows in each period.
DSCR definition

CFADS

DSCR

Debt Service
(Interest + Principal)
DSCR definition

DSCR reflects the ability of the project to service the debt

High DSCR means high debt capacity and low risk

DSCR below 1 means CFADS is insufficient to cover debt service

DSCR is a forward looking metrics


Required DSCR
Project DSCR Required DSCR

default
DSCR and Debt sizing

Project DSCR Required DSCR Higher Debt Capacity

Project DSCR Required DSCR Lower Debt Capacity


Excel calculation

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